State Issues First IOUs Since Great Depression : Economics: Promissory notes could reach the hundreds of thousands before California regains financial health.

With Gov. Pete Wilson and the Legislature unable to resolve budget differences, the state mailed IOUs in place of checks Wednesday to 12,000 people awaiting income tax refunds--the first time the state has been forced to use them since the Great Depression.

As the deadlock stretches further into the new fiscal year, more of the promissory notes will be printed and distributed, possibly reaching the hundreds of thousands before the state returns to financial health, officials said.

Sending the initial batch of IOUs was viewed as one more sign of the depth of the state’s fiscal woes by agencies that rate the safety of California’s bonds. One of those firms, Moody’s Investors Service, issued an alert Wednesday, describing the use of IOUs as “a cumbersome and disruptive arrangement not relied on since the 1930s.”

The credit rating firm said that if there is no new budget by Monday, it would re-evaluate the state’s bond rating--a signal that California faces a downgrade.

In the midst of the crisis, state Controller Gray Davis said he had no choice but to send the first IOUs, waiting for the last possible mail pickup in hopes that the governor and lawmakers would reach agreement on a spending plan for the fiscal year that began Wednesday.

Over the next several days, those who provide services and supplies to the state--such indispensable items as food for prisons and electricity for buildings--can expect to be paid in IOUs. And as the month wears on, some of those suppliers may not get paid at all, unless a new budget is passed.

“California is technically insolvent. We don’t have the resources to pay our bills,” Davis said. He noted that this year’s budget crisis was different from those in the past, when the state had surplus money to pay its bills but not the legislative authority to do so.

Known officially as registered warrants, the interest-bearing IOUs will probably be accepted as cash by most financial institutions if offered by regular retail customers. State officials said some banks were balking at extending similar services to commercial customers wishing to cash the warrants.

All three private rating agencies said they were monitoring events in the Capitol closely.

Although none of the agencies currently give California their highest rating, the state’s bonds are generally just a notch below that. And among the major industrial states, few have better credit ratings.

A drop of just one notch on the various rating scales could cost California $40 million for every $1 billion in bonds that it markets, state Treasurer Kathleen Brown said.

“It is of critical importance for our ratings, and for a whole host of other reasons, for the state to produce a balanced budget and soon,” Brown said. “I don’t see this dragging on for months. The banks won’t accept it, and the people will see this as a public disgrace.”

California is one of four states that did not have budgets in place in time to begin the new fiscal year Wednesday. The others were Illinois, Massachusetts and Rhode Island, but none were forced to issue IOUs.

The other major credit rating agencies--Standard & Poor’s and Fitch’s Investor Service--have placed the state’s bonds on “credit watch” status.

The controller’s office has been revising its schedule of IOU payments almost daily, as it struggled to determined what bills must be paid even without a budget--and which of those are to be paid in IOUs or cash.

Generally, payments to public schools, the University of California and bondholders will continue to be paid in cash.

As for the rest of the bills, there are myriad constitutional requirements, statutes and court decisions that require some to be paid while others will not be.

For example, later this month, whether there is a budget or not, the counties and cities can expect a regular payment of $392 million--the local share of sales tax revenues. However, a $192-million payment to local government--the local share of vehicle taxes--cannot be paid without legislative authorization.

In earlier budget crises, the courts have required that the state make welfare payments and pay government workers. The welfare payments will be made with a combination of regular state checks for the federal share and IOUs for the state share. State employees will be paid with IOUs.

If the impasse on the budget continues until the end of the month, the state will have to send out 800,000 warrants worth between $1.4 billion and $1.6 billion.

The state’s 427 banks watched warily as the first IOUs were mailed and hopes for a solution deteriorated.

Banks have put Gov. Wilson and state legislators on notice that they would not for long tolerate a situation under which they were being obliged to lend the state massive amounts of money rather than risk the wrath of customers.

“If every bank cashed every warrant issued, $1.6 billion would be taken out of the banking system monthly,” Larry Kurmel, executive director of the California Bankers Assn., a San Francisco-based trade group, said in a statement Tuesday. “Banks have been asked to cash instruments which are nothing more than IOUs, advancing billions of dollars to the state.”

Bank of America, the state’s largest bank, vowed to negotiate registered warrants at face value for all current customers--individuals and businesses--at its more than 1,400 branches statewide. (That includes branches still under the banner of Security Pacific National Bank, with which Bank of America recently merged.)

Customers may deposit warrants in automated teller machines, said Richard Beebe, a spokesman at the bank’s San Francisco headquarters.

However, Beebe said, “we’re assessing the situation day to day, and our action is subject to change.”

At Wells Fargo, also based in San Francisco, customers are being asked to take their warrants to their branches in person rather than deposit them in ATMs, said spokesman Michael Larkin. Larkin estimated that Wells Fargo’s more than 600 branches would handle $150 million of the $1.6 billion in state warrants issued monthly.

The bank’s policy will be to accept the warrants during July. “Should the budget situation drag on into August,” Larkin said, “the people who set this policy” would re-evaluate it.

Even though banks would collect 5% annual interest on the warrants once they were redeemed by the state, Kurmel said the industry would not profit from them because of special handling costs and attendant risks. He noted that banks have no way of knowing how long they would be forced to hold the warrants before they can be redeemed.

Most large credit unions and S&Ls; also can be expected to allow their regular customers to cash the IOUs.